By: Ted Sutton, Esq.

Sean and Scott are very successful entrepreneurs who live in San Francisco. They have had good fortunes investing in tech startups, and both have become very wealthy. Being shrewd with their money, they both decided to invest $5 million of their net worth into paper assets. Wanting to protect these holdings, Sean set up a Wyoming LLC. Because Sean is a California resident, Sean registered his Wyoming LLC in California and paid the $800 franchise tax. Scott found out that out of state trusts do not have to pay that dreaded fee, so he set up a Wyoming Statutory Trust for his portfolio. He named himself as the trustee, and he and his wife as the beneficiaries. By setting up the trust, Scott thought that he would end up paying less tax than Sean. As it turns out, he ended up paying more. A lot more.

As all our California clients know, a Wyoming holding LLC owned by a California resident must register with the California Secretary of State and pay the annual $800 franchise tax. The state’s position is that if a California resident is owning and managing a Wyoming LLC, then that entity is doing business in California. Their position infuriates a good many people, and we are frequently asked if there are any ways to avoid this fee. One potential solution, mentioned above, is the Wyoming Statutory Trust. Some use a Delaware Statutory Trust, or “DST,” but the problematic results are the same. We will use Wyoming as the example from here on out.

What exactly is a Wyoming Statutory Trust? It is a trust registered with the secretary of state that combines attributes of a standard trust and an LLC. Like a trust, a grantor puts assets into the Statutory Trust, to be held by one or more trustees, for the benefit of one or more beneficiaries. Like a Wyoming LLC, a Wyoming Statutory Trust has the same charging order protection if the beneficiary is personally sued. This trust is created by filing a Certificate of Trust with the Wyoming Secretary of State. Both the certificate and the annual report each cost $100. As a perceived bonus, California does not require these foreign trusts to pay the $800 franchise tax every year. Forming Wyoming Statutory Trusts will save our clients hundreds of dollars every year, right?

Wrong. The California Franchise Tax Board classifies out of state Statutory Trusts as “business trusts.” In two of their recent Chief Counsel Rulings, the FTB held that while these out of state “business trusts” are not subject to the franchise tax, they are subject to California’s 8.84% corporate income tax.[1] On top of this, a California Court of Appeals case recently held that trustees who are California residents are taxed at California rates on trust property located in another state.[2]

Do we really want our clients to pay this tax? As explained below, paying the $800 fee is a much better option.

Back to the example above. For simplicity’s sake, let’s say that Sean and Scott each earned $1 million in taxable income from their Wyoming entities in their first year. The diagram below shows how much each must pay to California and Wyoming.

Because Sean has an LLC now worth $6 million, he will have to pay a $1,200 license tax to Wyoming.[1] This fee arises from assets held in Wyoming. If they were held outside of the state, the fee wouldn’t apply. If he used a Nevada LLC, which has no such license tax, the annual fee would be $350. In addition to the $800 franchise tax, California also requires LLCs who make $1 million a year to pay a fee of $6,000. Sean’s total here is $8,000. However, Sean will be able to deduct the $800 California fee on his tax returns.

Scott, on the other hand, does not have to pay the license tax, the franchise tax, or the LLC fee. However, because the Wyoming Statutory Trust is a “business trust,” Scott’s income is subject to the 8.84% corporate income tax rate, even though this income came from Wyoming. On the $1 million Scott earned from his Wyoming Statutory Trust, he is footed with the California corporate tax. This means Scott must cough up $88,400. While Scott “saved” $2,000 by not paying the taxes Sean had to, Sean ended up saving $80,400 in taxes altogether. To make matters worse, this example doesn’t even account for other federal and state taxes that affects them both.

Whose situation would you rather be in: The person who paid the franchise tax, or the person who avoided it?

As it stands right now, there is a lot of inconsistency in how California chooses to tax out of state trusts. Some will argue that if the trust distributes income to the California beneficiaries, the income is taxed at the beneficiary level. But what if the income is held in the trust? What if it is reinvested? Some people will claim their DST has never been assessed an 8.84% tax. But this area is filled with unsettled law and strategy uncertainty.

A key point to remember when seeking to reduce minimum franchise taxes: The trust tax here is on the books. And California is always searching for more tax revenue. Should a favorable ruling come out, we will reconsider using Statutory Trusts for our clients. But we aren’t holding our breath. We advise our California clients to stay away from the Statutory Trust ambiguities. If you don’t, you could end up like Scott: paying costly and unnecessary taxes.

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[1] Franchise Tax Bd. Chief Counsel Ruling 2016-01 (February 17, 2016), and Franchise Tax Bd. Chief Counsel Ruling 2016-02 (February 17, 2016).

[2] Steuer v. Franchise Tax Bd., 51 Cal.App.5^th 417 (2020).

[3] For Wyoming LLCs, the Annual Report License Tax is the greater of $60, or two tenths of one mil on the dollar ($.0002).

By: Ted Sutton

What a Q-Sub is and How It Can Help Your Business

Diane has been obsessed with dogs from a very young age. She was very close with her childhood hound, and enjoyed spending time with other dogs she knew. After the hound’s passing, she vowed to make a career out of tending to our four-legged friends. She kept her word into adulthood. After graduating high school, she set up a dog store in town. Like a responsible business owner, she properly formed an LLC taxed as an S-Corp for the store.

After setting up shop, Diane soon discovered that there were very few dog grooming services in town. Given this business opportunity and her passion for dogs, Diane decided to capitalize. A few weeks later, she set up a dog grooming service in the dog store.

Over time, Diane began establishing a rapport with her clients. She noticed that many of them dropped off their dog for grooming before work and picked them up after the work day ended. What were the dogs to do after they had been groomed? Because the dogs spent all that time with her, Diane decided to provide a dog walking service.

Now Diane is in charge of three separate businesses operating under the same LLC. She has employees who work for all three and has separate obligations for each. Diane has a lot on her plate. She begins to worry about the direction of her businesses. What will she do with employee payroll? What if someone slips in the dog store? What happens if a dog bites someone while on a walk?

To address these fears, the IRS has a solution. Diane can set up Q-Subs for each of her businesses.

What are Q-Subs?

A Qualified Subchapter S Subsidiary (Q-Sub) is an S-Corp that is 100% owned by a parent S-Corp. Both the parent entity and the Q-Sub can be a corporation or an LLC. Parent S-Corps can own more than one Q-Sub, but they must make the election for each Q-Sub by filling out Form 8869 on the IRS website. This election must also be timely filed. If it is not, the Q-Sub will be taxed as a C-Corp.

Because the parent S-Corp files the tax return, the Q-Sub is not treated as a separate entity for tax purposes. However, Q-Subs are still responsible for a few things. Q-Subs must still obtain an EIN number from the IRS. Q-Subs are also separately responsible for some taxes, including employment taxes, some excise taxes, and certain other federal taxes. They should also follow all the corporate formalities (i.e. annual minutes) of a separate entity.

How they can help your business

There are a wide range of benefits that Q-Subs offer for business owners.

Q-Subs aid business owners when their S-Corp has more than one business activity. The S-Corp can limit its liability by separating its different business activities into different Q-Subs. Having this structure is certainly advantageous from an asset protection standpoint. Here, Diane only has one LLC set up for her dog store, dog grooming business, and dog walking business. Because Diane is concerned about liability, she sets up two separate Q-Subs for the dog grooming and dog walking businesses. In the event a dog bites someone on a walk, that person can only reach the assets inside the Q-Sub set up for the dog walking business. This business structure is diagrammed below:

Q-Subs come in handy when there are state and local transfer taxes that apply to sold property. In some states, transferring the property to a Q-Sub in exchange for 100% of the Q-Sub’s stock can avoid these types of transfer taxes. Let’s say that Diane lives in a state that allows these transfers without incurring tax. After setting up the Q-Sub for the dog grooming business, she wants to transfer title to the dog grooming tables into the new entity. If this transfer involves the dog store owning 100% of the dog grooming company’s stock, Diane will not have to pay any transfer taxes.

The IRS provides business owners with incentives when forming a Q-Sub. An S-Corp can deduct up to $5,000 in organizational costs the first year the Q-Sub is formed. After setting up the new dog grooming and dog walking businesses, Diane incurs $17,000 in such costs during the first year. Because the IRS offers these deductions, she can deduct $10,000 in organizational costs between the two new businesses, and deduct the remaining $7,000 in later years.

Businesses with two or more related entities use Q-Subs to minimize employee payroll taxes. When employees work for two related corporations, one corporation can set up a Q-Sub to employ the employee to avoid any double tax. Diane employs people who assist with the dog store, dog grooming, and dog walking. Instead of placing them on the payroll of all three entities, Diane sets up a third Q-Sub to employ everyone who helps with all three. This will prevent Diane from overpaying on payroll taxes. This business structure is diagrammed below:

Instead of filing separate tax returns for each entity, the parent S-Corp only needs to file one tax return for itself and its Q-Subs. At this point in time, Diane owns the dog store, dog grooming business, dog walking business, and a Q-Sub that employs everyone. With four entities, Diane thinks that tax season will be a nightmare. Fortunately, only the dog store will need to file a tax return on behalf of all four businesses. This certainly makes life easier for everyone during tax season.

Q-Sub elections are useful when S-Corps are bought and sold. If one S-Corp buys a second S-Corp, the first S-Corp could elect to treat the second as a Q-Sub.

Jack is a well-known figure and has the only doggy daycare in town. Many of the clients who buy products at Diane’s dog store give their dogs to Jack when they take a trip. At this point in time, Jack has run the daycare for over 30 years. While he also shares a passion for dogs, he decides that it is time to move on and calls it quits.

Diane views this as a perfect opportunity to add to her growing repertoire of dog businesses. Diane approaches Jack with an offer to buy the daycare. Jack is excited by this proposal. He can cash out, retire, and buy that coveted house in Hawaii to spend the rest of his days with his wife.

Both agree to the arrangement. After consultations from competent accountants and attorneys, Diane uses the dog store to buy the doggy daycare. The dog store now owns four Q-Subs, but both parties are happy. Diane has a near monopoly on dog products in town, and Jack can finally retire to Hawaii. This business structure is diagrammed below:

Lenders may want to create more lending protection by requiring S-Corp borrowers to hold loan collateral in a Q-Sub. After buying the doggy daycare from Jack, Diane realizes that she needs more kennels to house the growing number of dogs staying overnight. This will not be a cheap purchase.

Diane decides to buy the kennels on credit and approaches the bank seeking a loan. After reviewing her business credit, the bank tells Diane that they will need the kennels to be held as collateral in a Q-Sub. Fortunately, the doggy daycare business is already a Q-Sub. Both parties agree to the arrangement, and the kennels are held in the doggy daycare business as planned.

Given the numerous benefits that Q-Subs provide, business owners should consider forming them in the right circumstances. They helped Diane. And if you are faced with similar issues, they can certainly help you.